Markets: Where Do We Go From Here?
New York: November 04, 2003
By John R. Stephenson

Last week we saw some pretty impressive numbers released
by the Fed. According to the most recent statistics, the economy
surged to an annualized growth rate (as measured by GDP) of
7.2% in the third quarter. This most impressive of achievements
hasn’t been seen for more than twenty years. Add to
this the mega-merger of Bank of America and FleetBoston and
we have some pretty bullish news. But for some strange reason,
equity markets were remarkably well behaved in spite of this
impressive news. The S&P 500 did manage a solid gain of
21 points or nearly 2.1% for the week, however, it didn’t
seem like the kind of warm reception one would expect for
such a great number. The reason? The market is looking beyond
the numbers to earnings growth in the upcoming quarters.

The market trades on future expectations for earnings and
as such the market had already priced in the strong third
quarter economic numbers. With the third quarter earning season
winding down and the giddiness that accompanied stronger earnings
growth dissipating, can the party continue? To be sure Wall
Street had something to cheer about over this last quarter
with average revenue increases of 5.6% and operating earnings
increasing at 17% for S&P 500 companies, profitability,
at least for a while, appeared to be back in fashion. The
real question is: can market levels be sustained going forward?

It would seem to be somewhat more difficult to imagine such
giddiness in terms of earnings in the upcoming few quarters.
For starters, most economists see gross domestic product (GDP)
growth in future quarters falling back to the 3 or 3.5% level.
A far cry from where it is today. Our own analysis indicates
that fully half of the robust 7.2% growth rate was the result
of mortgage refinancing and tax cuts. With the economy growing
at a more modest clip of between 2 and 3% in future quarters,
it seems unlikely that the economy will add a significant
number of jobs which will keep a lid on overall economic growth.

Add to the mix a growing and ever enveloping series of scandals
in the financial services industry. Most recently, Lawrence
Lasser the CEO of Putnam Investments (the country’s
5th largest mutual fund company) was fired for allowing hedge
funds to trade in and out of funds in the aftermarket. With
New York Attorney General Elliot Spitzer hot on the heels
of just about everybody in the financial services industry,
it will be a while yet before that important ingredient of
trust returns to the market. Absent of trust, look for the
individual investor to stuff his savings under the mattress.
The institutional investors will continue to scrutinize the
numbers and will find them wanting in quarters to come as
most of the gains have come as a result of restructuring rather
than robust economic activity. With the tax savings spent
and with liquidity starting to dry up (see Figure 1) it seems
unlikely that the economy can mount a decent encore performance
to its third quarter number. Look for markets to head lower
in the coming months.

Figure 1: M2- Money Supply

Source: Federal Reserve Bank of St. Louis

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